Energy Recovery (ERII) was incorporated 1992 and went public in 2008. The company produces energy saving solutions for desalination plants. Over the past few years, it has been developing a number of products to address the needs of other fluid intensive industrial processes, mainly related to the oil and gas industry.
The companies legacy business and initial reason for existence, was to provide energy saving devices for desalination plants. My admittedly simplistic understanding of the companies products is that they allow for the conservation of pressure that would otherwise be wasted as pressurized waste water flows out of plant.
Here is a nice video explaining the product better than I can: https://www.youtube.com/watch?v=Y4Yk2Srs4XM
The company went public at an unfortunate time. As the global financial crisis caused its customers to cut capex, ERII’s operating leverage worked against them and the company floundered. In 2011, ERII got a new CEO and was able to recover its revenue and operating margins within a few years. Today it claims to service 90% of the desalination market for its products.
Though it has managed a strong comeback from the dark-days of 2011, the desalination business only generates $50 million in annual revenue and little to no profitability.
The vast majority of ERII’s value is related to several product initiatives that the company is pursuing. All of these products involve applying its pump and conversion technologies to some stage of the oil and gas industry.
ERII’s most promoted product is called VorTeq. It was developed for the hydraulic fracturing industry (AKA fracking). Fracking involves blasting sand and various chemicals into rock formations underground in order to liberate fuel. The problem for fracking companies is that the materials used to blast apart the rocks also cause a lot of wear and tare on the pumping infrastructure. As a result, fracking operations have many expensive pumps on site so that when and if one goes down, the company doesn’t have to stop work entirely.
ERII wanted to use their fluid engineering expertise to create a solution to this problem and that is the VorTeq. As you can see from the diagrams below, the company’s vision is for the VorTeq to replace the “missile” as a go between for the pumps, water and the blender. The ideal result being that by using the VorTeq, fracking companies will save money by employing fewer pumps, less water, and less money/time fixing damaged pumps.
The company has produced a working prototype of the VorTeq and in a partnership with Liberty Oilfield Services, they plan to test it in the field over the next 6 -12 months. If the product is fit for commercialization, the company expects to lease the VorTeq for $1.5 million annually and thinks there is a $1.3 billion total addressable market for the product.
The second major product in ERII’s portfolio is the IsoBoost System. The IsoBoost System is designed to be placed into gas processing facilities. Gas processing facilities typically use three or more pumps to pressurize the fluid used to breakdown unpurified gas. ERII’s value proposition is that by using the IsoBoost system, gas processors could remove two of the three pumps. This would save, one, money from having to purchase and maintain the pumps and two, the energy recovered by running the depressurized fluid through the IsoBoost.
What the company failed to anticipate before marketing the IsoBoost is that plant managers are really more focused on downtime risk than energy savings. I.E. the risk that losing pumping capacity will shut down their entire plant. ERII estimates that it costs the “average” plant about $2.5 million per day to be shutdown. So even though the IsoBoost system may have been equal in redundancy to the standard three pump system, and save energy, plant managers were very hesitant to sign up because it is a career risk if the you buy the IsoBoost and it causes a shutdown but only a kind of accepted operational risk if all three of your pumps break. As Keynes said, “It is safer to fail conventionally then to succeed unconventionally.”
This may not be an insurmountable obstacle. A large customer recently informed ERII that they’d crunched the numbers, and that the IsoBoost system is actually more redundant than the current industry standard three pump system, and moreover that this can be proven statistically. To that end, ERII has hired a third party to analyze the data and plan to present their findings at the Turbocharge conference in mid 2015. If the companies can convince plant managers that their product actually increases uptime, and saves money, it should dramatically increase sales of the IsoBoost system. ERII estimates the total addressable market of this product is about $1.5 billion, which includes gas processing and the ammonia market.
The final major product in the companies pipeline – no pun intended – is the IsoGen. The IsoGen was created to harvest energy from oil and gas pipelines. Basically, when oil or gas goes downhill it can build more speed / pressure than is safe for the pipes or plants receiving it. What the pipeline companies do is create choke valves to slow the flow of fluid through the pipes. The energy lost from slowing down a massive amount of fluid is essentially wasted money. The IsoGen generates electricity by taking the energy in the fluid and converting it into usable electrical power. The company puts the TAM of this product at around $1 billion.
The Pros – Track Record – Balance Sheet – Insider Buying
It is great to see that ERII has a track record of delivering at least tangentially similar devices to real industrial customers in the desalination market. Recent contracts for the IsoBoost by Conoco Philips and a purchase of the IsoGen by Aramco show that big players take the company seriously enough to do business with them.
ERII’s balance sheet is reasonably intact as well. With ~ $34 million in cash on the balance sheet and zero long-term debt, the company is not in any immediate danger of going bankrupt.
Recent insider buying, and share repurchases is among the most compelling things about ERII. Over the last year former board member Peter Lorentzen has doubled his indirect stake in the company from ~6% to ~12%. Board member Mao Robert Yu Ling also purchased ~$250,000 worth of stock in the open market last year. Perhaps more importantly, the CEO, Thomas S. Rooney is also getting in on the action. In 2014 he requested that the board pay his bonus in stock options in lieu of cash. ERII awarded him options for 440,000 shares a strike price of $4.96 per share. The company itself has also purchased shares. Since 2012 the shares outstanding have declined from 52.6 million to 51.8 million as of the last 10Q.
With only $35 million of cash on the books and little to no operating profit to speak of, it is possible that ERII will have to raise additional capital in the event that their products do become successful. Of course the terms of this capital raise may be much more or less advantageous then they are today but it is a risk.
The markets for these products may be much more competitive than the desalination space the company has previously operated in. Although the 90% market share the company purports to command suggests a less than commodity market place. The lack of profitability in the market they already dominate should be of concern to investors.
Valuation – No One Knows Anything
The company trades at market cap of roughly ~$250 million and has no debt. I would think that the desalination segment could be sold for 1x sales. So essentially, you are paying $200 million for the product portfolio – maybe $180 million if you want to count some of their cash towards an enterprise value.
To value ERII’s product portfolio with you have to make reasonable guesses about the following:
- The true size of the product(s) potential market – both recurring and one time
- The amount of market-share that the company’s product(s) will capture
- The amount of additional capital required to address the acquirable market share
- The profitability of the product or products that achieve any market share
- The timing of any achieved profitability
It is very tempting to take managements estimates of a ~$5 billion addressable market and the historical gross margins of the desalination products to create a scenario analysis for the product portfolio’s value. In fact I did just that, but even before I did, I knew it was a joke. As someone once said, “More fiction has been written on Microsoft Excel than Word.” Here’s some of my recent work:
Keeping investing simple is usually a good thing. If you pay $50 million for this product portfolio, you are likely getting a good deal. At $100 million it’s harder to say, and at $180 million plus, it is anyone’s guess.
Insider Buying – What to Make of It?
The only indication I have that these products may be worth more than the market is currently giving them credit for is the management and insiders monetary vote of confidence vis-à-vis their share purchases. Which begs the question, what is that worth? Unfortunately this is another tough question without an easy answer.
To try and handicap the informational content of their purchases it may be helpful to ask the following questions;
- What kind of access to information do they have?
- What if any record of capital allocation do they have?
- What percentage of their net-worth does this represent / what degree of confidence do they seem to have?
For instance, if the insider buying the shares is John Malone, you probably want to buy, buy, buy. On the other hand, Ron Johnson comes to mind. Ron Johnson, upon becoming CEO of J.C. Penny invested over $50 million of his own money in to the company thinking that he could transform into, well I don’t know but it didn’t work and he’s probably going to lose it all. Management’s confidence in their firm certainly counts for something, but it doesn’t mean you should always invest alongside them.
6.4! Yes, 6.4, another meaningless number but a fair meaningless number in my estimation. The takeaway is that management buying isn’t something you can take to the bank or even effectively quantify but it is encouraging and should be monitored.
Conclusion – The Fear of Missing Out
To pay $50 million for a cyclical business and $200 million portfolio of unproven products is not the certainly not the dumbest thing anyone has ever done in the stock market. At the same time, you would need a lot more information than I have to say there is a demonstrable margin of safety here. But here’s the thing, I want to be invested in this company and I know exactly why; the fear of missing out.
If this company generates even a little traction with it’s VorTeq product the stock could easily double or triple, and I am going to be sitting here telling myself, “all the signs were there, (mostly management buying really) and you didn’t buy it, you’re an idiot.” And this is the motivation for a ton of behavior on Wall Street; the inherent ambiguity of stock valuation (the future itself perhaps) means that there is nothing more dangerous than a plausible idea.
Truly great investors have both the intellect to parse the plausible from the probable and the discipline to act on that knowledge accordingly. I aspire to be as cold blooded as Warren Buffett, but I still have a dose of the old animal spirits. So I took a very small tracking position for my personal account to quiet that evil optimist who hates to be left out of the big parade.
Disclosure: I am long shares of ERII. I may buy or sell ERII without notice. Something in this article is wrong! Please always do your own research.FULL POST